* HOW TO IMPROVE INVESTING: Most investors are always alert for ideas on how to gain profit. They should look at risk too. Only when you face potential rewards and risks, can you make a truly sound investment decision. See the enclosed special report for ways to view risk.
Silent shadows, children of dusk, are born with the setting sun. They are quiet images of pine that lengthen across the forest floor darkening with the dying day. Pencils of twilight filter in rosy shafts through the trees and the coolness of a summer's night falls. Eventide surrounds us with stillness, quiet and with calm. as we join this silent time of rest that is so much at peace.
July 4, 2000. The quiet woods at sunset – Merrily Farms at Little Horse Creek. With the holiday in full swing Merri and I stayed off the busy roads and headed up into the woods on the farm instead. While there, I cleared my mind to start mental preparations for the International Investment Seminar in Zurich where I will speak this upcoming September. The greatest way to prepare for three days of straight talking is to stop talking so I listened to nature all day instead.
In the upper meadows there are waving fields of wild flowers, like huge blankets of snow, in full harvest. Groves of hemlock, maple and birch loom in the mists of early morn. Reaching the woods before dawn, Merri and I slipped in quietly and spent the day sitting, and being, totally quiet. Watching the sun rise and set were the busiest activities of the day. Nothing else was busy or noisy except on several occasions a large flock of crows.
After a hearty lunch of hot, thick split pea soup with rice and chunks of fresh, home made bread, warmed over a camp fire and eaten on a flat, grassy nob where the views go on forever, we took a long hike around the land. Then we stopped at Fawn Meadow (where it is often possible to see fawns bounding away), and basked in the quiet, peaceful surroundings of this open area which is totally surrounded and hidden by pinewoods. The southern exposure made it a trap for the warm afternoon sun so we parked ourselves against a tree in the shade for just a little rest. The nap turned into a deep, long, rejuvenating, fresh air sleep.
When we awoke, the stillness of dusk had begun. Shadows flickered through the trees. The stillness grew. Everything, even the crickets went silent. We just sat there, until the night, in the silence and peace.
In this stillness I had some thoughts I want to share in this report with you about a groundswell of investors. They had become convinced over the last decade that U.S. shares were the best (maybe only) place to invest. But now they are now having second thoughts and many will abandon U.S. shares. This create risk in the market. Plus many more will invest abroad which puts the U.S. dollar at risk.
I was thinking about this because as U.S. indices have already dropped dramatically and recently the U.S. dollar has appeared soft. Market events remind me of thirty years past when I first started giving international investment recommendations. At that time the U.S. market was at the top of its largest bull ever. New issues were rampant, the dollar was king, and many investors thought the market would never fall.
But the market did turn and headed down. Over the next 14 years (1970-1984) the Dow barely rose (about 5% per annum on average). But in U.S. dollar adjusted terms the market actually fell and fell hard.
At that time, I had recommended five mutual funds.
Show the funds See how they performed.
This performance looks like these markets did very well and they did, but not as well as it appears. Much of this gain was due to the fall of the U.S. dollar, which made the fund's assets (held in other currencies) rise in U.S. dollar terms.
Today we face the same two risks, a weak U.S. stock market and a falling U.S. dollar. Protecting against the market is easy. We can simply get out and move into cash. But how do we protect against a falling U.S. dollar?
In the past my recommendation would have been to look for diversification in German marks, Swiss francs or Japanese yen. Today these options are not so viable. The yen appears overvalued and the return offered on yen investments almost zero. German marks are now wrapped into the Euro. The Swiss franc, though not part of EMU is practically linked (because the Swiss must export to survive with half their exports going to Germany) as well.
We have to be more sophisticated in our currency diversification. We have to diversify more broadly and nibble around the fringes of the Euro. Because of this I recently suggested a speculative diversification into seven currencies; the Polish zloty, Hungarian florin, Slovakian kroner, Euro, Mexican peso, Norwegian kroner and Turkish lira.
Furthermore I suggested that one consider leveraging this diversification with a yen loan to create a multicurrency sandwich.
This Multicurrency Sandwich portfolio yields 52.76% of potential profit using an existing $100,000 asset (which has a 6% yield) as shown in the example below to borrow as much as US$400,000 of Japanese yen at 1.5% for investment into the seven currencies.
Here is how this diversification works.
Currency Investment Return Yield
US$100K Original Asset earning 6% in AAA investment 6.00% US$6,000
US$ 50K General Electric Polish Zloty Bond AAA 11-2-02 17.06% US$8,530
US$ 50K Hungary Government Florin Bond A1/A 12-1-01 10.30% US$5,150
US$ 50K IFC Slovakian Kroner Bond AAA 10-8-01 8.72% US$4,360
US$ 50K Argentina Gvt Euro Bond B1/B+ 6-02-03 8.28% US$4,140
US$ 50K Brazil Government US$ Bond B1/B 5-11-01 8.39% US$4,195
US$ 50K Mexican Gvt 3 Month Peso Cetes Bond Baa3/BB+ 14.00% US$7,000
US$ 50K Norwegian Gvt NOK Kroner Bond AAA 31-05-01 6.77% US$3,385
US$ 50K Turkish Gvt Lira 3 Month Bond B1/B 32.00% US$16,000
US$400,000 Japanese yen loan interest 1.500% US$-6,000
Total return on initial $100,000 at risk 52.76% US$52,760
This portfolio diversifies into eight currencies, nine countries and increases potential earnings by almost five times. But the portfolio also creates substantial risks.
The purpose of this report is to show how to assess this risk to see if (or how much of it) makes sense to you.
Because of the wonderful nature of the Internet, this report is to a degree interactive. In the past when using paper and snail mail I would calculate the risk and send out the report hoping that each reader got it, knowing that many would not.
Here instead of calculating the risk factor, I am including a case study of a previous Multicurrency Sandwich to help you understand how to calculate risk. Then you can easily learn how to figure out the risk and see if this makes sense for you. But this report offers even more. Our webmaster David Cross has opened a bulletin board (BBS) about this report so we can create a dialogue and you can provide input to help the learning process.
Here is the Case Study. David will explain how to use the BBS at the end of this report.
Case Study – Yen-Peso Loan
This case study is based on the investment idea I introduced in December 1993 to borrow Japanese yen and invest in Mexican Pesos! I had previously put out the idea of borrowing U.S. dollars to invest in pesos so the recommendation to borrow yen was an evolution of this initial suggestion. Here is what I wrote at that time (1993):
“You may think I am wild and crazy suggesting you invest in Mexican pesos, with borrowed dollars. Now you will be sure of it because I suggesting you now borrow what has been the world's strongest currency, the Japanese yen, to invest in Mexican pesos.
“The key to success in using collateral loans is to borrow a currency when it is strongest and invest it in a currency that has been weak but is about to become strong.
“The yen has been very strong, but let's look at why I think it will become weak in U.S and Mexican peso terms.
“Japan has its troubles. Japan's success over the past 20 years has brought many of the same ills we in North America and Europe suffer. High labor costs are forcing Japan to export many of its factories and profits.
“One way Japan is solving high labor costs is by exporting its business knowledge. It is moving its manufacturing facilities out of Japan. I believe Japan was waiting in the wings just hoping that NAFTA would fail. Failure would have opened a ripe opportunity for Japan to make Mexico a more major trading partner. Japan would have profited enormously in later years when the U.S. was forced to open up to free trade with Mexico. With all its faults, NAFTA at least moved the U.S. in the right direction and stopped the Japanese from getting even more foothold in Mexico.
“This short term loss to Japan is just one of many current setbacks to the yen. Yen problems are both fundamental and cyclical. Since 1975, the yen has suffered three periods of abnormal strength. The first was in 1976 to 1978 when it advanced 37% versus the U.S. dollar. The second was 1985 to 1988 when it rose 51% versus the dollar. The third, which we have just seen started in 1990. The first two periods of strength averaged 42 months in length. This third period of yen strength reached its 42nd month in October 1993. In this third period, the yen advanced 32% versus the dollar and 50% against European currencies.
“After previous periods of strength, the yen sustained a period of weakness. After the last bout of appreciation in 1988 the yen dropped 25% versus the U.S. dollar.
“I think the yen is even more likely to be weak now because the first two periods of yen strength were not so hard on Japan's industry. Then the strength of the yen was offset by low Japanese wages. In the first wave of yen strength in 1976 to 1978, the nominal increase in wages for Japan was 27%, but at the same time U.S. and German wages rose more (U.S. +37%, Germany 33%). The same is true in the second period of yen strength during 1985 to 1988.
“In this third wave of yen strength, this is not true. Nominal wages in Japan rose higher than in the U.S. Today U.S. labor costs are lower than in Japan.
“Also U.S. capacity utilization is lower than ever before, while Japan's capacity utilization is higher than ever before. Utilization of capacity is a percentage of actual production compared to total production potential of a country.
“These negative current Japan economic features did not exist in the first two waves of yen strength.
“There are other reasons why the yen may well drop now.
” * Weakness Factor #1: Japan's Recession. The strong yen is creating high costs for Japanese products in the U.S. and other countries right at a time when the Japanese economy is in the doldrums. A review of the Global Economic Cycle shows that Japan is in recession and has not yet reached the bottom of the economic cycle yet. This recession means there are fewer buyers of goods in Japan. This puts pressure on Japan's businesses to sell as much abroad as it can. A strong yen makes this much more difficult.
” * Weakness Factor #2: Lower yen interest rates. The recession in Japan will tend to push yen interest rates down. Lower yen interest rates will reduce demand for the yen (and cause its strength versus the U.S. dollar to weaken). The yen interest rate last month fell for the first time in years below the U.S. dollar rate. This also reduces yen demand.
“* Weakness Factor #3: Important structural changes. Japan has really been canny over the past two decades. While saturating almost every market in the world with its products, they have managed to keep up barriers which keep the inflow of foreign goods sold in Japan at an absolute minimum. This has created huge trade imbalances all over the world. In the long run this really cannot continue. This is changing for at least two reasons.
“The first reason is that the barriers have been bad for the Japanese consumer. The import barriers in Japan do stop Japanese consumers from gaining access to many superior (and now much cheaper) products abroad. Though Japanese industry would like to maintain the many barriers and keep Japanese customers as their captives, Japanese government deregulation will increase exports to Japan. The new government in Japan led by Mr. Morihiro Hosokawa is consumer oriented.
“A second reason why this change will come about is that the many nations who have huge trade deficits with Japan are demanding better access to Japanese markets. Japan has been good at giving in on this as slowly as possible, but they must help equalize these balances and the time to do so is well past.
“All this means increased exports to Japan which will decrease the Japanese trade balance which will reduce demand for yen, which will add to the yen softness.
“* Weakness Factor #4: A Weak Stock Market in Tokyo. There is continued room for weakness in Japan's stock market. Normally a stock market starts to rise at the stage of Japan's economic Cycle. As interest rates drop, money shifts from bonds and deposits to the stock market. There is however several factors slowing the market there.
“One factor is the hangover that continues from the enormous bull market of the late 80s. Another is that high Japanese labor costs now make businesses there less competitive and thus not so attractive at the very high price earnings ratios that exist in Japan.
“These high labor costs also force successful well-managed Japanese businesses to other Asian countries such as China, Taiwan, Indonesia, Singapore, Malaysia, etc. These alternative stock markets, full of successful Japanese subsidiaries with much more attractive price earnings ratios, compete with Japanese shares.
“So where can a person invest in the yen? Interest rates are low and falling, the stock market is in a bind and the value of the yen is falling! This is a classic scenario where money flees a currency and its value falls.
“Now here is the interesting part! You can borrow yen at an even lower interest rate than the U.S. dollar. Right now for example, Jyske Bank in Denmark offers U.S. dollar loans at 4.875%. They offer yen loans at 3.875%! The one percent drop in the loan cost adds 4% per annum more to the return. In other words if you borrow yen to invest in pesos rather than borrow U.S. dollars you increase your return on money invested from 40% to 44%. If you invest $25,000 in this portfolio and if the yen and peso parity remain the same all year long, and if the interest rate parities remained the same as well, you will earn $11,520 on each $25,000 invested.
“This is only the beginning. It is possible that this investment can bring you a return of nearly 97% in 1994 (96.72% to be more exact).
“Here are the projections for how this profit can be earned.
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN MODEL DEC. 1993
“Convert $25,000 to Mexican pesos and buy Cetes 3 month T Bills Use the T Bills To borrow U.S. $100,000 of yen at 3.875%. Invest the loan in Mexican peso T-Bills as well.
$100k Mexican Peso Yield 12.00% less 3.87% 8.13% $8,130
Extra Earned From Loan $8,130
$25k Mexican Peso Yield 12.00% $3,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 44.52% OR $11,130
“This is just the beginning of the profit potential in this portfolio. We expect the yen to fall in value versus the U.S. dollar. The yen's fall can add an extra 52.10% of profit to the portfolio!
“In the U.S. dollar to peso model, the hope was that the peso/dollar parity would just remain the same. In the yen to peso model, we hope (and this hope is backed with great evidence) the yen will fall versus the U.S. dollar in 1994.
“If the peso and the dollar are likely to remain linked (as they are), and if the yen is likely to fall versus the U.S. dollar, then the yen is likely to fall versus the Mexican peso as well!
“At this time the yen is trading at 108 yen per dollar. Let's look at what a fall of the yen from the 108 level of 5%, 10% and 15% would affect our model portfolio.
“We borrowed US$100,000 worth of yen at 108, that is 10,800,000 yen.
“A fall of 5% would be 5.4 yen which would put the yen dollar parity at 113.4. Thus to buy back 10,800,000 yen would cost only US$95,238. You add an extra $4,762 (or an extra 19% profit) if the yen falls 5%.
“In total if the yen falls 5% and if you have invested US$125,000 worth of pesos of which US$100,000 has come from a yen loan, you make $15,892 return or 63.56%. You make 44.52% ($11,520) from the loan spread and $4,762 or 19.04% in foreign exchange profit.
“If the yen fell 10%, the yen dollar parity would be 118.8. It would cost only $90,909 to buy the $100,000 worth of yen to pay off your loan. You would make $9,091 or 36.36% of forex profit.
“In total if the yen falls 10% versus the U.S. dollar, you gain US$20,221 on each $25,000 invested or 80.88% total. You make 44.52% ($11,520) from the loan difference and $9,091 in foreign exchange profit.
“Now let's look at a 15% yen drop which would bring it to 124.2 yen per dollar. It would cost you only $86,950 to pay off the Yen 10,800,000 loan. You make $13,050 or 52.1% in foreign exchange profit.
“In total if the yen falls 15% versus the U.S. dollar you gain $24,180 on each $25,000 invested or 96.72%. You make 44.52% ($11,500) from the loan difference and $13,050 from foreign exchange.
“The big question is can the yen fall 15%? After the last wave of yen strength (it rose 51%), it fell back almost half the amount it rose. It fell 25% in two years. If the yen fell half as much as it has risen in this third wave (it rose 32%), it would fall 16%!
“So there are many reasons to believe that the yen – peso collateral loan can be a top winner for 1994.
“Now let's look at the risks! If the yen can fall 15%, we must also conclude that it could rise 15%. This seems unlikely in light of the evidence we have seen, but we should always know what will happen if our expectations are not met. We must review the risk in case our research missed something or we drew incorrect conclusions or the statistics and data we used were wrong. We must prepare for the unexpected.
Let's look at five risks we should review.
“* Risk #1: The bank where we hold our money goes broke. This is one of the least risks if you deal with a major bank. To reduce this risk here are steps you can take.
#1: Look at the bank's balance sheet. #2: Look at how long the bank has been in business. #3: Ask if there is any type of government or industry guarantee on your account. #4: See if the assets the bank holds for you will be held by the bank as a fiduciary. If so even if the bank goes broke, the assets should be safe unless fraud is involved. #5: Ask a banker or investment professional you trust to get a credit rating or reference on the bank.
“* Risk #2: The Mexican government defaults on its obligations. Even though Mexico has initiated significant reform and NAFTA has passed, the Mexican government's debt rating is still not of a high standing. Mexico's debt load from money borrowed in the 80s is still high, so we must take this risk as a major consideration. According to Standard & Poor's, one of the best known credit rating agencies, the Mexican government is rated BB+ and the outlook is stable. BB is not a Standard & Poor's investment grade rating. It is a speculative grade rating. Standard and Poor's defines their ratings AAA, AA, A and BBB as investment grade. BB, B, CCC, CC and C are speculative grade ratings. Mexico at a BB+ has the highest grade speculative rating, but one must keep in mind that this investment is a speculation.
“Standard & Poor's describe a BB rating as, “One with less near- term vulnerability to default than other speculative issues. However it faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments.”
“Do not discount this risk factor. This investment is a leveraged investment into a speculative issue.
“There are many positive factors that mitigate this risk. The fact this speculation involves only short term instruments (90 day T-Bills), that they are government debt and that Mexico would seem least likely to default right after the beginning of NAFTA are all positive factors that suggest the risk is minimal. The fact the return on these T-Bills has dropped (they paid over 17% last year) is a signal that the market is gaining confidence in Mexico's economic stability.
“Understand and decide whether or not to accept this risk. Do not ignore it!
“Recognize the reason this investment offers such high potential is because the international market place rewards those who take risk. You are being paid to back your belief that Mexico has changed and is changing even more for the better. If you are right you will be well rewarded. If wrong you could lose all and as you will see, you could lose even more than you invest!
“* Risk #3: The returns that Mexican Peso T-Bills offer could fall. If the Mexican economy strengthens and the perception of risk in holding these investments diminishes, it is possible that the return on these T- Bills will fall. As an example, let's look at what would happen to your investment if the yield dropped from 12% to 10% or 8%.
“There is no guarantee that the yield on these T-Bills will last longer than 90 days. These instruments are bought at a discount for 90 days. Right now, a thousand pesos worth of these bills could be bought for about 970 pesos. For the 970 pesos the bill promises to pay 1,000 pesos in 3 months (90 days). Thus one can roll them over four times a year. If the discount remains stable, slightly over (if compounding is taken into account) 120 pesos of profit can be made. The actual return is about 12.6%, but after converting to pesos and costs the return is just under 12%.
“For projection purposes, let's again assume an investment of US$25,000 into Mexican pesos 'Cetes' T-Bills. This is used as collateral for a US$100,000 loan also invested into Mexican peso Cetes T-Bills.
“Keep in mind that when we look at these performance projections we are looking only at the return before foreign exchange profit or loss. We will look at the foreign exchange portion of the profit in more detail later in this report.
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 10% T-BILL RETURN
“Convert $25,000 to Mexican pesos and buy Cetes 3 month T Bills Use the T Bills To borrow U.S. $100,000 of yen at 3.875%. Invest the loan in Mexican peso T-Bills as well.
$100k Mexican Peso Yield 10.00% less 3.87% 6.13% $6,130
Extra Earned From Loan $6,130
$25k Mexican Peso Yield 10.00% $2,500
TOTAL RETURN ON $25,000 INVESTED IS 34.52% or $8,630
PERFORMANCE PROJECTIONS OF YEN-PESO LOAN WITH 8% T-Bill Return $100k Mexican Peso Yield 8.00% less 3.87% 4.13% $4,130
Extra Earned From Loan $4,130
$25k Mexican Peso Yield 8.00% $2,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 24.52% or $6,130
“As you can see from the projections above, every time the return on the Cetes T-Bills falls 1%, the return on your portfolio falls 5%. With this knowledge we can project in advance the actual return (without the foreign exchange profit or loss factor) at each level of T-Bill yield:
T-Bill Yield Portfolio Return
“* Risk #4: The interest rate on the yen loan could rise. Normally your banker will not give you a fixed interest rate on your yen loan. The normal collateral loan is linked to the London Interbank Interest Rate and can change at any time. As with the peso yield fall, every 1% rise in the interest rate of the yen loan will reduce your return by 5%. The portfolio return projections above can thus be applied to see what happens to your profit if the yen interest rate rises.
“Again all of the above has been calculated without taking the foreign exchange fluctuations into account. However foreign exchange fluctuations between the yen and peso can have the biggest impact of all on this portfolio. It can bring the biggest profit, but also create the biggest loss! This is the fifth and largest risk.
“* Risk #5: The Mexican peso could fall versus the Japanese yen. We saw earlier how a 5%, 10% and 15% fall of the yen could add enormous profit to this portfolio. Now let's look at how a 5%, 10% and 15% rise of the yen will destroy the profits of this collateral loan.
“In the projections below, I calculated the projected losses in U.S. dollar terms, but if the peso fell versus the U.S. dollar, it could be that the yen rises versus the peso, but not the U.S. dollar. The results in real profits or loss would be the same, whether the U.S. dollar falls or not.
“As we reviewed earlier in our projections we have borrowed 10,800,000 yen when the US$/Yen rate is 108.
“If the yen rises versus the dollar (and hence the peso) by 5% the dollar/yen rate will be 102.6. It would cost US$105,263 to pay off the yen loan. The foreign exchange loss is US$5,263 or 21% of the US$25,000 invested.
“In other words, a 5% rise in the yen versus the peso would reduce the return on the portfolio from US$11,130 to US$5,867 (assuming the yen loan rate and the peso T-Bill yield did not alter) from 44.52% to 23.52%.
“If the yen rises 10% versus the dollar, the dollar/yen rate will be 97.2. To pay off the 10,800,000 yen would cost US$111,111,111. The portfolio suffers a US$11,111 loss or 44% of the US$25,000 invested. This reduces the 44.52% profit to almost nil.
“In other words, a 10% rise in the yen would reduce the return on the portfolio from $11,130 to $29 or almost no return at all. If the yen rises 10%, the portfolio just breaks even.
“If the yen rises 15% versus the dollar, the dollar/yen rate will be 91.8. To pay off the 10,800,000 loan would cost US$117,647. The portfolio suffers a US$17,647 loss or 70% loss of the initial $25,000 invested.
“In other words, a 15% rise in the yen would reduce the return on the portfolio from $11,130 to a loss of US$6,517 loss or -26% of the US$25,000 invested.
“And the loss can be worse because it will probably take a full year to earn the 44.52% profit on the spread between the loan rate and T-Bill return. The foreign exchange loss could come in a matter of months.
“If we assess our risk on a worst case scenario, we can imagine that just after the portfolio begins, the Mexican peso crashes in foreign exchange markets. Let's consider that the peso suddenly collapsed 15% versus the yen in the first two months after the portfolio started. The portfolio's return from the interest rate spread would be 7.42% (two months' worth of profit at the 44.52% annual rate), but the sudden foreign exchange loss would be 70%. The real loss at that stage would be 62.58%.
“Most banks would not allow a 70% loss without asking for additional collateral. If extra cash, bonds or securities were not available as extra collateral, most bank will liquidate the position. The loss in the portfolio becomes real, a real whopping US$15,645!
“If the yen rose 20% to 86.4 yen per dollar and peso the foreign exchange loss could be the full $25,000. If it rose even more than 20% and if the bank had not liquidated your position, it is even conceivable (though doubtful) that you could lose the entire US$25,000 and still owe the bank!
“There are risks involved in this opportunity that can make 96.72%.
“If you cannot afford to lose at least part of your original investment, then you should avoid this opportunity. Be sure you understand the risks and can afford to accept them before you use this tactic. Loan Ratio
“There is a way to reduce some of the risk. Reduce the amount (in percentage terms) that you borrow.
“The risk and reward of this idea are very much affected by the loan to investment ratio of the portfolio. So far in this report we have looked only at portfolios with a four to one loan ratio, which is a typical maximum ratio banks allow. However you can borrow less in relation to the amount you invest. Instead of borrowing four dollars for every dollar you invest, you can borrow, three or two or one or really any ratio between four and one. The amount you borrow is called the loan to investment ratio.
“Take for example a projection in which you borrow only three times the amount you invest.
PERFORMANCE PROJECTIONS WITH THREE TIMES LOAN TO INVESTMENT RATIO
$75k Mexican Peso Yield 12.00% less 3.87% 8.13% $6,097
Extra Earned From Loan $6,097
$25k Mexican Peso Yield 12.00% $3,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 36.38%% or $9,097
“If you borrow three times the amount you invest, you greatly reduce your risk of sudden foreign exchange loss. You give up 8.14% of your potential profit on the rate spread and of course also give up foreign exchange profit potential too. If the yen falls by 5%, you will make 14.28% foreign exchange profit (compared to 19.04% if you had borrowed four times the amount invested). A portfolio with a three times loan earns 50.66% profit with a 5% fall of the yen (versus 63.56% with a four times investment to loan ratio). “A two to one loan ratio is even safer and has even less profit potential as the projection below shows.
PERFORMANCE PROJECTIONS WITH TWO TIMES LOAN TO INVESTMENT RATIO
$50k Mexican Peso Yield 12.00% less 3.87% 8.13% $4,065
Extra Earned From Loan $4,065
$25k Mexican Peso Yield 12.00% $3,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 28.26% or $7,065 "With a two to one loan ratio, a 5% fall of the yen adds US$2,383
forex profit or 9.53%. The total profit would be 37.39%.
PERFORMANCE PROJECTIONS WITH ONE TIME LOAN TO INVESTMENT RATIO
$25k Mexican Peso Yield 12.00% less 3.87% 8.13% $2,032
Extra Earned From Loan $2,032
$25k Mexican Peso Yield 12.00% $3,000
TOTAL PROJECTED RETURN ON $25,000 INVESTED IS 20.12% or $5,032 "The forex profit on a 5% yen fall for a portfolio with a one to one
loan ration is $1,119 or 4.47% which means the total return on this
portfolio would be 24.59% or US$6,127 on US$25,000 invested. "Here are all the profit and loss potentials on three to one, two to
one and one to one loan ratios for 5%, 10% and 15% rises and falls of
the Japanese yen to the Mexican peso from the assumed parity of 108 yen
per U.S. dollar and assuming the U.S. dollar peso rate remains fixed. 3 to 1 2 to 1 1 to 1
Spread Forex Total Spread Forex Total Spread Forex Total 5% yen fall 36.3% 14.1% 50.5% 28.2% 9.5% 37.3% 20.1% 4.4% 24.5%
10% yen fall 36.3% 27.2% 63.5% 28.2% 18.1% 46.3% 20.1% 9.0% 29.1%
15% yen fall 36.3% 39.1% 75.4% 28.2% 26.9% 55.1% 20.1% 13.0% 33.1%
5% yen rise 36.3% -15.7% 20.6% 28.2% -10.5% 17.7% 20.1% -5.2% 14.9%
10% yen rise 36.3% -33.3% 3.0% 28.2% -22.2% 6.0% 20.1% -10.4% 9.7%
15% yen rise 36.3% -52.9% -16.6% 28.2% -35.2% -7.0% 20.1% -17.6% 2.5%
“These are your choices. Match the risk to your needs. The four to one loan ratio has 97% profit potential, but could lose all. The one to one ratio offers 33.1% in its upper range but chances of loss are far smaller. Even a 15% yen rise would still leave 2.5% profit over a year.
How to Choose Your Ratio
“There are three factors to consider when planning whether to make this investment at all and if so at which investment to loan ratio.
“* Factor #1: For how long can you invest? This is not a short term get in and out investment. You should plan to invest for at least a year to let the spread work for you. Unless the yen takes a sudden dramatic fall at which time you would want to consider taking a quick profit, this is a one to three year investment at the least. It could take two or more years for the yen to gradually drift down to a point where you wish to liquidate.
“* Factor #2: How is your staying power? The greatest risk in this portfolio is that just after you have started the yen has a sudden unexpected temporary rise versus the peso. If this should happen, can you afford to put up an additional US$12,500 or so per US$25,000 invested as additional collateral? If you can do so and believe the yen is overvalued, then you may want to risk a higher loan to investment ratio.
“* Factor #3: How much can you afford to lose? This is a speculation. You could lose all your money. Do not speculate with savings that you cannot afford to lose. Don't use your emergency funds. Don't use the money you have set aside for your kids' college education. Don't mortgage your house in the hopes that you are going to make some great profit. Don't risk your pension.
“The more important the need and the sooner the need for that money will be, the lower the loan to investment ratio should be.
“In addition you should consider how you feel about taking risk. Some investors worry so much about their investments that the stress and strain to their nervous system is not worth any profit they might make. Stress can kill you! Don't jump into this speculation if you are going to worry about it every single day. Put your money in some investment that feels safe to you instead.
“So can you earn 90+% in a year or does this sound too good to be true? Check all the facts and figures again. I've looked at them often. Each time, I feel this opportunity is better in every way. Good luck if you use it!
Later the peso became stronger, then crashed and was devalued. However we had moved out of the peso by then for two reasons. One is that just months after we made this investment the yields on the peso bonds began to fall. Second US equities were so hot. In mid 1994 (before the peso crashed) I wrote.
“I am still in the yen-peso sandwich. When I recommended it in December, the yen was 108. Today it stands at 111, a 2.7% fall. In addition during that time, my Mexican bonds have returned at an extra 8.125% rate above the yen loan. In other words, the position is up about 4% in two months and growing. But the peso position is now a much smaller part of my portfolio because of opportunity I see in equities.
“Note that it is the weakness of the yen that offers the biggest profit potential in the above tactic, not the interest differential. Because of this, I now believe the hottest tactic in 1994 will be investments in stock markets financed with yen loans.”
Looking Back from 2000 Perspective
Shortly after this event we liquidated the peso position entirely and the position turned into what one could consider a perfect dream investment. The yen interest rate fell gradually from the three percent level all the way down to 1.5% (where it remains to this day. The stock market roared into the hottest bull ever. This position of high earnings and low costs latest for years until the yen eventually fell to 146 yen per dollar adding an extra 35% profit (multiplied four times to 140% for those who borrowed four to one). At 146 I recommended to readers to take their profits and get out.
But we cannot say that the investment was entirely smooth because the yen rose from 111 all the way to 79 before finally falling back to 146.
Case Study Conclusion
Steep, green gables and ancient roof lines cut sharply in the clear blue sky. Antique walls reflect on the morning's brilliance and are decorated by wild parrots that flash lime and screech through the dawn. They squeak noisily now seated amidst ancient oak. Caressed by a fresh sea breeze, we listen to the sun awakening and feel its excitement rise. This is a new day, wise in its uncertainty and offering riches for all.
Merri and I were at water's edge near the Belleview Mido Resort, in Clearwater, Florida strolling in the dawn near this wonderful old hotel known as “The White Queen of The Gulf”. Built in 1897, it sits high on a bluff and combines old world charm, from the antique-filled Henry library to the Tiffany Ballroom with its priceless skylights of stained glass, to its private resort setting. The hotel offers many accommodations that include cozy sun parlors, charming balcony suites and was the site of one our international investment courses.
I will never forget this hotel because I learned perhaps the most valuable lesson of all about calculating risk from two of the delegates at that course. As I arrived at the Belleview to check in, even before I reached the registration desk, one of the delegates, a heart surgeon, approached me and vigorously shook my hand. “Gary,” he said, “I cannot thank you enough. I have followed your recommendations about borrowing yen to invest in pesos and shares and have made so much money, I have been able to buy a house on the beach in my homeland and can now retire.”
I felt a glow as I walked away headed for the check-in counter of the hotel. One always feels good having helped a client and friend. I was happy that the doctor had made a lot more profit than I did. I am conservative with my own investments and had only borrowed two to one. This doctor had borrowed four to one and had held on during the yen rise.
The warm feelings did not last. Still before I could check in another delegate, also a medical professional, collared me. “Gary,” he said, “I am not even sure if I should be here. I followed your advice borrowing the yen to invest in peso and shares and lost every single penny.”
It turned out he had chosen to borrow six to one. When the yen appreciated and he was faced with putting up substantially more money, he decided to cut his losses.
The lesson is clear. Three investors (two doctors and myself) with similar backgrounds and exactly the same information had three totally different results!
Know your risk and know yourself before you speculate and especially before you use leverage. With this lesson in mind, my next two courses (available for $29-free to International eClub members) will be more on how to calculate currency value and the psychology of investing. (How to know thyself when investing better.)
To conclude this course, web master David Cross explains how to use the BBS to post your answers, questions and comments about calculating risk…
– – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – Our BBS is at https://www.garyascott.com/forum/ – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –